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EMD Outlook 2018: Robust global growth lifts emerging markets

31/01/18

Robust global growth and strong EM fundamentals are expected to boost EMD performance in 2018. Political risks or monetary policy normalisation in developed markets are unlikely to derail our constructive view.

In our EMD asset allocation we currently prefer hard currency debt, particularly the frontier markets, but during the course of the year, when the opportunity arises we may change our preference to local bond markets.

2017: A strong year in terms of performance

Emerging market (EM) fundamentals started improving in 2016 and accelerated last year, with growth broadening across regions and countries. The recovery in commodities, led by the metals segment, is a reflection of improving global trade growth and a strong investment cycle in both developed and emerging market economies.

This resulted in strong performances across the different EMD sub-asset classes. EMD hard currency sovereigns returned 10.3% in US dollar terms, driven by the higher yielding part of the HC universe, also known as the frontier markets. The NexGem index, which reflects the Frontier Market Debt (FMD) universe, delivered a 15.7% total return. EM local bonds followed closely with a total return of 15.2%, while hard currency corporate bonds returned 8%. Asian hard currency debt returned 5.8% in USD terms.

2018 returns driven by solid global andEM fundamentals

We believe that 2018 will be another positive year for EMD and that the improved fundamental picture will allow risk premiums to compress further.

Prospects for global growth are robust; we expect the synchronized upturn in both developed and emerging economies to continue, which will fuel global trade growth.

Chinese authorities will most probably aim for quality over pace of growth in the next few years, as the focus on structural reforms has increased. We believe China can continue growing at a very decent pace of 6-6.5% in the next few years.

China thus remains a key driver of EM GDP growth, which we expect to increase from 4.5% in 2017 to 4.8% in 2018. The risks to this growth forecast are on the upside; if the state of the global economy continues to improve, we believe growth in EM economies may be even stronger.

External balances of many emerging markets have improved considerably over the past few years, as current account deficits have been dramatically reduced.

Real interest rates are still high in emerging markets, which not only provide higher risk premiums for investors but also a buffer for local central banks against the need to hike interest rates.

EM currencies have regained some ground, especially versus US dollar, but based on real effective exchange rates they are still undervalued by some 15%.

Levels of indebtedness have declined since they peaked in 2015, which is another indication of improving fundamentals.

Investor demand expected to remain strong

In addition to the favourable fundamental dynamics, the technical picture is expected to be supportive. Demand for EMD is strong; portfolio flows into the EMD asset class in 2017 reached their highest level in the past decade at USD 112.8 billion. We believe such inflows will continue. One reason is the GDP growth gap between developed and emerging economies, which bottomed out in 2016 at around 2%. Since then it has increased and we expect it to widen further in the coming years (see chart). Historically, the correlation between portfolio flows and this growth differential is strong.

Politics or policy unlikely to derail our constructive view

Our constructive view on EMD is largely based on improving fundamentals and the attractiveness of the asset class relative to other fixed income markets. We see a few potential risks, which are however not expected to derail our positive view.

Monetary policy normalization, particularly in the US, will cause some upward pressure on bond yields. On its own this will not derail the positive EMD picture, but combined with an upside surprise in inflation, contributing to a more-hawkish-than-expected stance by the Fed, it may lead to increased volatility.

US protectionism, which many feared a year ago but has so far not played out, is still a risk. We don’t see this as a big risk for 2018, especially now that the US tax plan has been approved, thus lowering the need for President Trump to show his teeth in other policy areas. The threat of protectionism should also not be ignored as the US might still get tough on countries with large trade surpluses versus the US, including China, South Korea, Japan and Mexico. We believe pragmatism will ultimately prevail as any protectionist measures from the US will likely meet with retaliation, which will impact the US economy.

Geopolitics are nearly always a lingering risk; an escalation on the Korean peninsula or in the Middle East cannot be excluded.

Rising geopolitical tensions can drive up oil prices, which are supported by the deal between OPEC and other oil producers to limit supply, and by stronger demand resulting from higher economic growth. On the other hand, rising oil prices will incentivize US shale producers to increase production, limiting the upside for oil prices. On balance, therefore, prices should remain relatively stable.

All in all, we don’t consider any of these risks to be serious enough to derail the favourable outlook for EMD.

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